Should You Buy a Stock After a Dividend Cut?

Although I’m relatively dividend agnostic, I do appreciate a nice dividend. Something like 60% of stock returns over time have been because of dividends, and studies have shown that companies that grow or maintain their dividends over the long-term do better than those who cut or eliminate their periodic payout to investors.

I get why people want to invest in dividend-paying stocks. Hell, I even get why they’d want to invest exclusively in dividend growth stocks, even though I don’t think that’s a strategy that’s going to perform terribly well over the next decade. It’s nothing against the kinds of stocks these investors like. They’ve just become really overvalued.

Besides, it turns out doing the opposite actually works pretty well. Instead of investing in a stock that keeps increasing its dividend, you should do the opposite. You should invest in the company that has just announced a dividend cut.

Dividend cuts as a bull signal

Nelson, you’re insane. Why would I want to invest in a company that has just cut its dividend? Isn’t that a pretty clear sign there’s big problems?

You are correct, yet wrong at the same time. KEEPING YOU ON YOUR TOES.

Companies don’t cut dividends for chuckles and/or giggles. It’s a very serious decision taken by a management team that has no other choice.

It’s also something many astute investors can see coming. Dividend cuts aren’t like your immature college friend; they don’t jump unexpectedly out of the corner under the guise of a funny joke. They’re a result of months or even years of steadily deteriorating results.

Remember when oil crashed starting in the summer of 2014? It took months for most oil companies to slash their dividends. It also wasn’t much of a secret that oil company earnings were going to suffer when the price of oil kept falling. This isn’t rocket science, chumps.

The story is the same for most other stocks that end up cutting the dividend. All you need to do is look at free cash flow. If it’s persistently negative, a dividend is at risk. The degree of risk might not be that easy to find, but the universal truth of a company cannot pay out more than it takes in remains.

Because sentiment will usually predict a dividend cut before it happens, you’ll see two things happen to a stock. First, it’ll go down, and secondly, the dividend yield will get very high. Astute investors are betting on the fact a dividend cut is inevitable.

When the day comes and management finally makes the fateful announcement, something interesting often happens. The stock will actually go up on the news.

You know the expression “it’s darkest right before the dawn?” When a stock announces a dividend cut, many contrarian guys consider such an event that dark moment.

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Then what happens?

For the most part, it turns out the contrarian investors are right. Stocks that cut their dividends have usually bottomed.

In fact, according to a Morgan Stanley study on European stocks over the last decade or so, buying when a stock announced a dividend cut has been a massively good idea. After a year, the median dividend cutter has outperformed the market by 11%. After two years the spread is even more pronounced, with the average cutter delivering a 19% outperformance. The probability of a dividend cutter outperforming the market in the two years after the event was approximately 66%.

There’s another wrinkle to the study too. The stocks that did worse in the year leading up to the dividend cut tended to do the best the year after. When sorting for stocks that did the poorest leading up to the dividend cut, Morgan Stanley found almost 90% outperformed the market after two years.

This confirms a thesis I’ve believed for years. Investors who buy the trashiest stocks will end up making the most money. And what’s worse than buying a stock that has just cut its dividend?

So to answer the question in the title, yes, you should buy shares of companies that just announced a dividend cut. As long as you do it smart, you’ll end up richer than somebody who just sticks all their cash inside an index fund.